Global Economics

Netanyahu Embraces New Economic Thinking

With unemployment up and exports down, Israel's next Prime Minister is casting off laissez-faire philosophy in favor of more state intervention

The economy played only a minor role in Israel's recent election campaign, which was largely overshadowed by the December military operation in the Gaza Strip. But in recent weeks, a continuing sharp decline in key indicators has forced Prime Minister-designate Benjamin Netanyahu to focus almost exclusively on efforts to revive the economy. This time around, though, Netanyahu—who formerly served stints as Prime Minister and Finance Minister—is dramatically toning down the free-market and noninterventionist policies that were his trademark in the past.

"He has already become half a socialist, and I hope that in his next term he'll become a full socialist," quips Ofer Eini, chairman of the Histadrut Labor Federation. The powerful union leader already has met several times with Netanyahu since the election. Eini is looking to cut a deal with the new government and the country's industrialists within the next few weeks in an effort to halt the spreading layoffs that have affected nearly every sector of the economy.

Israeli unemployment, which hit a two-decade low of 5.9% in the third quarter of 2008, is now projected to rise to 8% or more by the end of this year. "It will take time until the economy changes course, and I ask you to make every effort to limit the spread of unemployment," Netanyahu appealed to the country's top business leaders at a Mar. 15 gathering in Tel Aviv.

Infrastructure Push

The business community has been largely supportive of Netanyahu's recent efforts. "The government needs to initiate infrastructure projects and enable the banks and insurance companies to extend immediate credit to companies in order to prevent unemployment," says Israeli tycoon Yitzhak Tshuva, the major shareholder in the Delek Group (DELKG.TA), a leading energy, infrastructure, and services conglomerate.

The hawkish Likud leader isn't just meeting with the country's business elite. On Mar. 16, he sat down with some of Israel's leading social activists to get their input on ways to deal with the recession and help the growing ranks of unemployed and poor.

Netanyahu is expected to finalize his right-wing government in the coming days. His efforts to bring the centrist Kadima party into the ruling coalition so far have failed. And he hasn't yet named a finance minister, though close ally and Knesset Member Yuval Steinitz appears to be the front-runner. Bank of Israel Governor Stanley Fischer rejected an earlier offer. Netanyahu even hinted at one point that he might take on the post himself and appoint a respected outsider to oversee day-to-day operations of the key ministry. In any case, it's clear that Netanyahu will be making most of the decisions.

During the campaign that led up to the Feb. 10 general election, the Likud leader sounded a few familiar economic themes, including a promise to lower the top personal tax rate to 35% from 46% and the top corporate rate to 18% from 27% over a four-year period. But since then Netanyahu has only paid lip service to cutting taxes and has concentrated instead on saving jobs. "The types of tax reforms that Netanyahu implemented 5 to 10 years ago are no longer relevant in the current economic climate," says Momi Dahan, a Hebrew University economist and public policy expert.

Screeching Halt

Israel was largely spared the initial impact of the economic downturn felt in most Western economies during 2008. After five years of unprecedented growth, gross domestic product rose 4% last year. But the economy came to a screeching halt in the fourth quarter and now is deteriorating rapidly. Industrial production fell 1% in the final two months of 2008, and retails sales dropped 2%. The biggest impact of the global slowdown has been on Israeli exports, which plummeted at an annualized rate of nearly 25% from December to February.

Israel's Manufacturers Assn. is predicting a 10% drop in industrial exports this year—the sharpest ever recorded. And the once-vibrant high-tech industry, which accounted for more than 40% of Israel's $40.1 billion in export sales last year, has been particularly hard hit.

"High tech is facing a double whammy from the shortage of funding and a sharp drop in demand from abroad," says Yoram Oron, managing partner at Vertex Venture Capital, leading Israeli venture fund. Companies have laid off thousands of workers, cut wages, and in many cases resorted to a four-day workweek to survive. Even that may not be enough for many of the 2,000 or so startups that have traditionally formed the backbone of the local high-tech industry: Oran predicts that 20% to 30% of local venture-backed firms will be forced to shut down in the coming year.

In recent months, the Bank of Israel has tried to help the economy by cutting its base interest rate to an all-time low of 0.75% and has bought dollars to weaken the shekel and help exports become more competitive. But on Mar. 10, the bank revised its forecast downward for the fifth time in the past year. It's now predicting the economy will contract by 1.5% in 2009, the worst performance in the six-decade history of the Jewish state.

Tax Shortfall

In an effort to deal with the crisis, Governor Fischer presented his own plan calling for $1.1 billion in additional government investment in infrastructure, education, and industrial research and development. The central bank now expects the government budget deficit to rise to 5.2% of GDP in 2009, up from only 1.7% last year. That's partly because of planned spending increases, but also due to an unprecedented drop in tax revenue in recent months as the recession took hold. "Israel does not have too much leeway to increase government spending because of the already high ratio of debt to GDP," says Fischer. The central bank predicts that if its plan is implemented, recession and unemployment could be eased somewhat by the end of this year and Israel could return to growth in 2010.

In the meantime, Netanyahu has set up an economic transition team led by likely Finance Minister Steinitz. The "100-day team," as it has been dubbed, will make its recommendations later this week. The team's stimulus plan is expected to include state guarantees for refinancing corporate bonds, loans to small and midsize businesses, and government assistance to companies to prevent more layoffs. No price tag has yet been revealed.

In the past, Netanyahu got a lot of credit for Israel's economic performance. But this time around the laissez-faire policies that helped transform the country's formerly left-leaning system aren't likely to stem a crisis that's largely the result of global forces. Netanyahu will have to be far more flexible than before—and even adopt policies that would have been previously anathema. He can hardly be blamed for Israel's current economic situation, but if his government fails to halt the deterioration, his past achievements will recede quickly from popular memory.